Bitcoin 101

By: John J. Sierotnik

Over the past year, Bitcoin, a new alternative virtual currency was in the news almost every week. Since its creation in 2009, Bitcoin use has grown exponentially. It now has a presence in nearly every country in the world. Mainstream businesses including and Microsoft have also begun to accept Bitcoin for ordinary transactions.

1. What is Bitcoin?

Bitcoin is a virtual currency that exists on the Internet. Just like the Dollar or the Euro, one can use it to buy goods and services or exchange it for real-world currencies. Some also hold Bitcoins solely as an investment.

2. Where can one get a Bitcoin?

There are two ways of obtaining a Bitcoin. First, just like any other currency, one can receive Bitcoins as a gift or in exchange for other currency, goods, or services. Second and what is unique about Bitcoin compared to physical currencies is that one can obtain Bitcoins in a process known as mining where individuals or teams compete with others around the world to see whose computer can solve a complex math equation (that also processes all the Bitcoin payments) the fastest. This mining process is how new Bitcoins are created and introduced into circulation.

3. Where are Bitcoins located and how can they be spent?

Unlike most other assets, a Bitcoin has no natural physical location associated with it and instead exists on a global network of computers. When one spends a Bitcoin, the transaction could be processed anywhere in the world. Spending a Bitcoin requires the private key to a Bitcoin, which is similar to a long, complicated, password, and can be stored online or in the physical world.

Just as it is possible to give someone an already purchased $25 gift card in exchange for $25 worth of other property, without involving the store or creating any other record of the exchange, Bitcoins can be exchanged offline simply by sharing the private key. However, similar to calling the 1-800 numbers on the back of a gift card, the only way to be certain someone else has not already spent a Bitcoin is by verifying its value online. This is why offline transactions, while possible, are risky.

4. Who is behind Bitcoin?

No government or central bank controls Bitcoin. At its core, Bitcoin is an open-source software product like the Firefox browser you may be reading this on. A small group of developers is responsible for making any changes to Bitcoin such as the rules governing the creation of Bitcoins and the spending Bitcoins. However, because those mining Bitcoins and processing Bitcoin transactions could decide not to adopt a modified version of the software and those accepting Bitcoins for payment could decide to stop doing so, the developers must be responsive to the desires of market. Additionally, as it is an open-source project, there is nothing preventing an alternative group of developers from implementing their own changes and having their modifications accepted by the marketplace instead of the changes made by the “official” Bitcoin developers.

5. What does the IRS think about Bitcoin?

The IRS has recently issued a Notice that classifies Bitcoin as property and not as a foreign currency. This means that the IRS treats Bitcoins just like any other piece of property for tax purposes. One is potentially subject to taxation both when they receive a Bitcoin and on any gain over their basis in the Bitcoin when they spend it. As the fair market value of a single Bitcoin has varied dramatically over short periods of time (sometimes hundreds of dollars within the span of a few days), conducting a transaction in Bitcoins could potentially pose dramatic, unforeseen tax consequences for either the buyer or the seller if it is not planned carefully.

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